The Real effective Exchange rate (later exchange rate) has a significant influence on the behavior of the economic agents. Therefore, in order to establish the effective macroeconomic policy it is vital to analyze its fundamentals and their impact on the exchange rate. The aim of this paper is to study the effects of fiscal policy, specifically the effects of the budget expenditure on the exchange rate dynamics for Georgia.

According to the various economic studies, the link between fiscal policy and exchange rate can vary significantly. For example, based on the Real business cycles (RBC) models spending shocks increase output and produce the negative wealth effects leading to an increase in the labor supply, a decrease in the real wages and the private consumption, and no change or the depreciation of the real exchange rate. On the other hand, the Neo-Keynesian models suggest that a positive shock to the government spending can lead to an increase in the output along with the rise in the public spending, which in turn can raise the demand for the labor and cause an increase in the real wages. Consequently, the private consumption can increase and the real exchange rate appreciate.

The Parliamentary budget office of Georgia evaluated short-term impact of the government spending shocks on the exchange rate. The different models shows the different results for Georgia’s economy: The OLS error correction model shows, that the government spending shock leads to an exchange rate appreciation, but this model is characterized with the weak relationships between the indicators and statistically non-significant estimations. The second approach, 3 factor structural vector autoregression (SVAR) model, which was based on the cholesky decomposition, predicts that the budget spending shock may cause the exchange rate deprecation during the first year but for the second year it will be transformed in the nonsignificant appreciation. The baseline SVAR model includes five variables. It is also modified so that it takes into account futures of Georgian economy. The baseline SVAR model shows that the increase of the government expenditure leads to a nonsignificant depreciation of the real effective exchange rate, causes a small increase of the consumer price inflation and in the “ceteris paribus” leads to the nonsignificant nominal exchange rate depreciation.

For more details see the complete document (available in Georgian)